The Deficit: A Danger or a Blessing?

January 15, 2004

By Christopher Farrell "The spirit of a people, its cultural level, its social structure, the deeds its policy may prepare, all this and more is written in its fiscal history.... He who knows how to listen to its messenger here discerns the thunder of world history more clearly than anywhere else."

-- Joseph Schumpeter

By the Schumpeter standard, the message from the federal government's fiscal stance is muddled. What's disturbing is how the ledger made a $700 billion swing from a record surplus in 2000 to a record deficit now. What's ambiguous is how worried Americans should be about the red ink.

According to O'Neill, no one in the White House's upper echelon worries about the fiscal impact of tax cuts. Vice-President Dick Cheney is quoted as saying that "Reagan proved that deficits don't matter." The fiscally conservative O'Neill, who fretted about the looming budgetary drain from an aging baby boom generation, was unceremoniously shown the door.

CAN'T SAY NO. Some observers believe the Administration's fiscal recklessness will end in catastrophe. Princeton University professor and The New York Times columnist Paul Krugman is a harsh critic. In his column of October 14, 2003, Krugman argues that the gap between what America spends and what it takes in is so large that the nation will eventually careen into a major financial crisis. "What will the plunge look like?" asks Krugman. "It will certainly involve a sharp fall in the dollar and a sharp rise in interest rates. In the worst-case scenario, the government's access to borrowing will be cut off, creating a cash crisis that throws the nation into chaos."

Others aren't convinced -- and not just supply-side zealots that never met a tax cut they didn't like or a budget deficit they feared. Take the perspective of historian John Steele Gordon, the author of Hamilton's Blessing: The Extraordinary Life and Times of Our National Debt. As a general rule for managing government finances, Gordon dislikes deficits, especially the tide of red ink spilled during the 1980s that largely reflected Congress' and the Administration's ability to say no. Yet he notes that in the 1860s, the national debt saved the union, in the 1930s it shored up the American economy, and in the 1940s it saved the world. The current deficit is a "a blessing," he believes.

"It's a blessing because a national debt properly funded is a powerful tool that allows us to guard America's security, whether economic or military," Gordon says. Fiscal policy reflects the pressing need to fight terror and lean against the recession, and "we can afford the debt," he adds.

OLD-FASHIONED APPROACH. I lean more toward the concerned side of the intellectual debate. Still, whether you believe the deficit reflects irresponsible fiscal management or a rational response to crisis, one thing is clear: Better numbers are needed. The current budget picture is a short-term snapshot that doesn't take into account long-term financial obligations. And long-term capital expenditures are lumped with short-term bills.

Most mainstream economists and Washington budget experts agree that the federal government's bookkeeping makes Enron's accounting look like a model of clarity. Despite the recent spate of accounting scandals, the development of sound bookkeeping practices dramatically limits the room for mischief by scoundrels. The same would go for politicians.

One suggestion Gordon puts forward is for the federal government to create an independent body modeled along the lines of the Federal Reserve Board. Its members would be insulated from politics by enjoying extended, staggered terms. The staff could be made up of mostly tenured university professors who are experts on government finance. This watchdog's job would be to keep the books honest as well as easily understandable to the average citizen.

THE 1800S RULE. At the same time, it might be a good idea to dust off an old idea: Why not separate capital spending from the ordinary budget. In a recent paper, economists Marco Bassetto and Thomas Sargent call the accounting technique the "1800s rule" since this was common practice among national governments in the 19th century. State and local governments still manage their books in this manner.

In the 1800s, governments could issue debt only to finance capital items like roads. As future generations benefit from such spending, it only makes sense that they would help pay for it. As for everything else, the ordinary budget had to be paid when the bill came due. According to Bassetto and Sargent, John Maynard Keynes remained a fan of the "1800s rule" even after the Great Depression.

Keynes believed it was good government policy to insist on separating capital spending from the ordinary budget. This way it would be easier to understand what part of the budget is going toward long-term investment and how much is needed to meet short-term obligations. Of course, the temptation to label all spending as investment will be mighty, but it might not be as easy to manipulate the figures as it is now.

Neither of these reforms will be easy to enact. But they might help put the government's finances on better -- or at least more understandable -- footing. Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over Minnesota Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BusinessWeek Online